The P/E ratio stinks at predicting where stocks are going

The stock market’s price/earnings (P/E) ratio will tell you if the market looks cheap, expensive, or fairly valued.

When it’s below some long-run average, the market is cheap. When it’s about average, like it is now, the market is expensive.

Unfortunately, just because stocks are expensive, it doesn’t mean investors should immediately cash out and prepare for imminent price declines.

“P/E has a poor track record for predicting shorter-term returns,” BMO Capital Markets’ Brian Belski writes.

Belski tested the relationship between P/E and the 12-month returns using R2, a statistical measure which reveals how well a regression line — the line of best fit you see — explains the relationship. The higher the R2, the better better job a P/E ratio does in explaining returns.

“According to our work, the simple P/E ratio explains a significant portion of longer- term stock market returns (e.g., 10 years+, Exhibit 1),” Belski said. “On the other hand, P/E ratios have little explanatory power for holding periods up to 10 years.”

The fact of the matter is that P/Es aren’t that reliable over any given period. It’s just worse in the short-term, which at ten years is still a rather long time.

“Therefore, we believe investors are likely overstating the importance of elevated P/E levels as it relates to potential market performance in the coming months,” Belski said.

In February, Citi’s Tobias Levkovich ran a similar R2 test to show that the cyclically-adjusted price-earnings ratio does an absolutely horrible job of explaining 12-month returns.

“Although we do not discount the possibility of periods of market weakness — especially given the stage of the current cycle — nothing in our work suggests an imminent end to the current bull market,” Belski wrote.

Belski maintains a 2,250 price target on the S&P 500.

NOW WATCH: Nationwide’s Super Bowl commercial about dead children is about corporate profits … in a way that we can all appreciate

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.